1 EC111 MACROECONOMICS Spring Term 2012 Lecturer: Jonathan Halket Week 22 Topic 8: OPEN ECONOMY MACROECONOMICS So far we have considered only a closed economy. Now we turn to looking at macroeconomics when the economy is open to transactions with the rest of the world through trade and payments. The key distinction between international transactions and internal transactions is that the former involve the exchange of one currency for another. If a UK resident wants to buy something produced abroad then she must first buy foreign currency in exchange for pounds, in order to pay the foreign producer. In practice it is often the retailer (or his supplier) who does this. Similarly a foreign purchaser wishing to buy something produced in the UK must buy pounds in exchange for foreign currency. The balance of payments account of a country records the total value of transactions which involve an exchange between home and foreign currency. The balance of payments accounts form part of the national accounts, and are recorded in terms of the domestic currency. Transactions that appear in the balance of payments accounts are normally divided into current account transactions, capital account transactions and official financing. A simplified version of the Balance of Payments Credit Debit Net Exports of goods Imports of goods Visible trade balance Invisible exports Invisible imports Invisibles balance = Current account balance (1) Investment from abroad by foreign residents Investment abroad by domestic residents =Capital account balance (2) Official financing (3) Note that the sum of (1) + (2) + (3) must add up to zero. For every pound sold in return for foreign currency, someone must have bought a pound and sold units of foreign currency. If more pounds are sold by UK residents than are bought by foreigners for transactions in goods and services, then the value of imports exceeds the value of exports and there is a deficit on the current account. This is a current account deficit (sometimes referred to as the trade deficit). In this case there must be an offsetting surplus on the capital account plus official financing.

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If there is a deficit on the current and capital accounts combined, more pounds have been sold than have been bought for private transactions. The Bank of England must have bought pounds in exchange for foreign currency. Its foreign currency reserves will have declined. In reality things are more complicated. Note that: Britain normally has a deficit on visible trade and a surplus on invisibles. What we think of as the capital account is now (5) + (6) + (7). Official financing is (8). In the statistics the Balance of payments as a whole does not add up to zero. Why not?

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